March 15, 2001

For many years, the Brookings Institute published a book following the release of the federal budget beginning with the works, Setting the Nationís Priorities. What are the priorities President Bush is setting by the budget he has just sent to Congress?

The fact that I now think the probability of recession is more than 50% and that the stock market plunged to 2 year lows this past week are coincidental, at least partially.

Two areas of weakness even raised the prospects that a recession was possible. They were the inventory excesses that built up during the fall and the weakening consumer confidence after the summer.

Once an inventory imbalance is identified, production will be curtailed and goods sold from the warehouse until inventories improve. While this creates temporary layoffs, sagging profits and production declines, it is limited. The only danger appeared to be that weakening consumer confidence could cause sales to continue falling. Then production would be falling merely to reflect the weakening sales without using any warehouse stock.

I never thought this was a real possibility because large government surpluses allowed a significant reduction in taxes while the Federal Reserve could slash interest rate targets sharply without threatening rising inflation. Of course, I expected those forces to be unleashed, as they partially have been.

However, two more areas of weakness have surfaced, and the dimensions of the inventory correction are larger than expected.

While auto producers rapidly slashed production from 12 million vehicles to less than 10 million at annual rates in less than three months, the technology sector apparently was slow to realize they had an inventory problem. Even in January, inventories of computer equipment, communications equipment and electronics components continued to grow at double digit annual rates.

The old economy is well along in adjusting to its inventory problem. The new economy has barely begun. As a result, inventory investment declines will persist into the summer, and the technology sectors will suffer the brunt of what adjustment is left.

Weak technology sales are partially the result of hesitant capital spending. In the first half of 2000, capital spending excluding construction was growing at a 20 percent annual clip. In the fourth quarter, it suffered a 4 percent annualized decline. A plunge in available equity financing for new enterprises certainly accounts for some of this weakness. For example, about $36 billion of venture capital was distributed in the first quarter of 2000. By the fourth quarter, allocations had dropped by more than a third.

However, the plunging stock market and falling profits have combined to stall capital spending decisions for even the mature companies. Some of the startling revenue markdowns by Cisco, Intel, Motorola, and others reflects the rapid flattening of order books as companies reassess their growth prospects for the next year.

The fourth area of weakness is the world economy. Earlier Latin America and Europe appeared to be avoiding any serious slowing while the Asian slowing was credited to higher energy prices, which were beginning to subside. Unfortunately, the Asian problem appears more heavily rooted in its poor capital allocation system (including its banks), which is not being fixed in a timely fashion.

Even without a declining stock market, those four areas of weakness would be sufficient to threaten recession in the U.S. and possibly through many parts of the world. However, the $4 trillion drop in wealth in the past year cannot be offset by $9 billion of tax stimulus that is brought forward into this year by the Bush administration.

Although Senator Phil Gramm believes that consumers will respond this year to tax cuts that will not be made until 2005 or 2006, this has not been the behavior of consumers in the past. Indeed, some economists have argued that the 1982 recession was so deep because the Reagan tax cuts were phased in over three years. People did not change their behavior to respond to the tax reductions until all the gains were in place.

The Bush tax cuts are a megaphone, beginning slowly and then growing loudly. They will not be a factor in offsetting all that lost wealth anytime soon.

The falling stock market also has created the reassessment of capital spending that is threatening that area of spending. To offset these adverse responses, the Federal Reserve must lower interest rate targets faster than profits are slowing. In that fashion, the value of future profits will become more important even as current profits are disappearing.

The Fed began this year aggressively, lowering my fear of recession. They since have become cautious even as economic conditions in the U.S. and globally have continued to deteriorate. Another dose of aggressive interest rate target reduction is needed fast, or the four areas of weakness will create the recession of 2001 (and eliminate most of that revenue surplus in the next few years that President Bush is hoping will finance his tax initiative).

I remain hopeful, because this recession can be avoided by appropriate, timely policies. Unfortunately, the likelihood of such policies is rapidly diminishing

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